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Determination of cost of capital

Cost of capital is not only most crucial but also it is a controversial area in the financial management decisions. Under this background, determination of cost of capital is not a simple task. The finance manager has to face a lot of problems both conceptual and practical while determining the cost of capital of the company. Major problems in this regard are as follows.

(i) Conceptual Controversy. There is a major controversy whether or not the cost of capital is dependent upon the method and level of financing by the company. The traditional theorists pointed out a firm can change its overall cost of capital by changing its debt-equity mix. But the modern theorists argued that the change in the debt-equity ratio does not affect the total cost of capital of the enterprise.

(ii) Computation of Cost of Equity. The determination of cost of equity capital is also a difficult task. In the actual theoretical point of view cost of equity capital may be defined as the minimum rate of return that a company must earn on its capital employed. So the market price of the equity shares remain unchanged. This implies that to find out the cost of equity capital one has to require quantification of the expectations of the equity share holders. It is a very difficult task because different authorities have tried different approaches to quantify the expectations of the equity shareholders.

(iii) Problems in Computation of Cost of Retained Earnings and Depreciation Funds. Cost of retained earnings and depreciation fund is determined according to the approach adopted for computing the cost of equity capital which is itself a controversial problem.

(iv) Problems in Consideration of Historical Cost, Future Cost. As per the decision making point of view, the historical cost is not relevant. But future costs should be taken into account. This brings another problem whether to consider marginal cost of capital i.e., cost of additional funds or whether to consider the average cost of capital i.e., the cost of total funds.

Problem of Weights. In order to ascertain the average cost of capital, the financial manager of the company has to face the problems of weights. In this aspect, computation as well as assigning of weights to each type of fund is a complicated problem. Because, there are two options in this respect, i.e., book value weights and market value weights. Both of them have their own strengths and weaknesses. It is natural but results based on the two aspects differ significantly.